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Goldman's Pesky Fly Could Become a Wasp

Thousands of class action suits could soon gain traction.

Financial institutions are well accustomed to the courtroom. Since banks first started littering our streets, there are people who have felt wronged by them and who have sought restitution. Since the financial crisis, class action suits against the major banks in the United States have gone through the roof -- many times for good reason. But it's hard to take on one of the financial leaders of the world, even if the law firm representing you has eight last names in its title. Now, a recent court decision against Goldman Sachs(NYSE: GS) may set precedent for a new wave of suits -- of the clothing and legal kind.

Ya jerks!It's certainly not hard to make Goldman Sachs look like a bad guy these days. The company has been subject to an enormous amount of scrutiny, from the SEC to the average Joe. It seems everyone wants a piece of the investment bank that received the high school notable "Most Likely to Ruin Your Life."

The company has been adept at handling the salvo of allegations condemning its business practices. There have not been too many major judgments against the company in the wake of the financial crisis. Slightly less evil Bank of America(NYSE: BAC) has had harsher consequences in the courtroom. The company has had to pay millions here and there for anything from overcharging its investment-banking clients to negligent corporate behavior. Things could get a bit hairier for Goldman Sachs, though, as a federal appeals court recently revived a 2008 case against the company for misleading customers in regard to its mortgage-backed-securities business.

Specifically, an electrical workers' pension fund enlisted the aid of a major law firm to open a class action suit against the company for what it claims was an attempt to mislead investors about the inherent risk in the home-loan portfolios, many of which were constructed before the housing crash in 2007 and 2008. Goldman was not the only part involved, but it was the leader of the effort backed by Bank of America, JPMorgan Chase(NYSE: JPM), and others.

Realistically, this class action suit is of little consequence in and of itself. The damages, if awarded, would barely move the needle for the $56 billion bank. Standing alone, the case is little more than another fly on Goldman's back. What is troubling, though, is that the revival of the case by a New York Federal Appeals court could pave the way for the thousands of other alleged victims of the mortgage-backed-securities debacle. If one lawsuit goes through, you can be sure law firms will be lining up to represent investors.

Me and 10 million othersWhat's also interesting is that the three judges have decided to allow the plaintiffs to represent investors not directly involved with their own case. This is very similar to the University of Michigan affirmative action case, where the plaintiff was seeking damages using not only his particular instance, but also that of thousands of other affected parties. The basic question here: Can someone sue over a securities issue when that person didn't purchase the securities in question?

Judges have swayed to either side of the argument in the past. In the University of Michigan case, the plaintiff was allowed to represent others, but in a 2010 case involving Bank of America, the judge required the suit be narrowed to specific securities, a decision that brought the case from more than $300 billion to just over $30 billion in mortgage-backed securities.

As mentioned, Goldman can handle a lot of legal costs -- it's built in to the company's fee structure. What the company and its fellow banks do not need, though, is a line out the door of people seeking restitution for the wrongdoings of pre-financial-crisis-era investment banking. Investors in Goldman, Bank of America, JPMorgan, and others are wise to keep an eye on this developing case.

Understanding the hurdles and opportunities facing a company is crucial in making an investment decision. Check out this premium report in which our analysts lay out the future of Bank of America. It comes with a full year of analyst updates, too, so make sure you claim your copy.